MBA's in crisis- who makes the grade?

At many top business schools, students toil under heavy expectations of success. They are constantly reminded of distinguished alums who head companies and government organizations. They are told that upon graduation they are expected to become "leaders" that others will look to for direction. This aspiration is admirable, if maybe a little self-important. It is certainly an improvement on the commonly held perception that people only go to business school so they can make obscene amounts of money.

So do business schools produce good leaders? Should one follow an MBA graduate to anywhere other than an expensive bar? True leadership usually emerges in a crisis. In today's economic crisis, how are MBAs performing?

To answer that question, The editorial staff of the Review did a survey of the companies and organizations that are involved or have been heavily affected by the credit crisis. It turns out there are a lot of MBAs running around. We have collected a sample of MBA leaders and evaluated their performance, assigning them a grade on an A-F scale. Staff members had differing views on how people had performed, so the scores were averaged to provide a composite grade. The only criteria for selection were that they held an MBA and were in a leadership position of a company/organization directly involved in the financial crisis.

Please note that these grades are not intended as a critique of specific business schools, nor are they meant to pass judgement on the motives or character of the individuals evaluated. Rather, they are intended to provide a sample analysis of how MBA graduates have performed as leaders during this crisis. As any shrewd investor knows, past performance is not necessarily indicative of future results, and these grades should be treated accordingly.

______________________________________________________________
A
John Paulson, President, Paulson & Co.
MBA- Harvard Business School

Image: Reuters

This NY-based hedge fund manager shares a surname but no familial relationship with Treasury Secretary Henry Paulson. The Paulson in question predicted the subprime collapse back in 2006 and bet his money accordingly. This year he has posted 20% returns while the hedge fund industry as a whole slipped by the same amount, earning him the moniker the "King of Subprime."

______________________________________________________________

A
John Stumpf, CEO Wells Fargo
MBA- University of Minnesota
Image: Reuters

While other banks foundered in the subprime waters, Stumpf steered his bank clear of mortgage backed securities. In October, he used Wells Fargo's strong balance sheet to snatch Wachovia from right under Citibank's nose

______________________________________________________________
A

Robert Diamond, CEO Barclays Plc

MBA- University of Connecticut
Image: Getty

In September, Diamond completed a stunning $1.35B raid of the bankrupt Lehman Brothers, grabbing most of its core assets including its Manhattan headquarters. In an effort to be humane to former Lehman employees he has delayed rounds of expected layoffs until 2009. While the U.K-based Barclays hasn't been immune to losses from subprime exposure, they have been able to survive thus far without taking government capital.
_______________________________________________________

A
Jamie Dimon, CEO JP Morgan Chase & Co.
MBA- Harvard Business School

Image: Reuters

Jamie Dimon could be aptly described as the Charles Darwin of the financial sector. A serial acquirer, Dimon has used the crisis to snap up both Bear Stearns and Washington Mutual. If and when crisis finally subsides, JP Morgan will have scampered its way to the top of the financial sector food chain.

_______________________________________________________________
B+

John Thain, CEO Merril Lynch
MBA- Harvard Business School
Image: Getty

It is perhaps a sign of the times that a CEO who presides over a 75% drop in a company's stock should receive a passing grade. But Thain's singleminded determination to avoid bankruptcy helped save a storied Wall St. firm. Meanwhile Lehman Brothers and Bear Stearns burned to the ground with their CEOs at the fiddle. Thain would have received an "A", were it not for his recent tone-deaf decision to pursue his management bonus.

_______________________________________________________

B
Henry Paulson, Treasury Secretary

MBA- Harvard Business School

Image: AFP/Getty

By the time Paulson was installed as head of the Treasury in mid-2006, the stage was already set for the crisis that has unfolded. Paulson's failure to act quickly and consistently allowed things to snowball. Yet throughout the crisis he has been the one individual in the federal government who has shown anything resembling leadership: dutifully marching to capitol hill to take abuse from a hysterical congress, pulling all-nighters then rushing over to do the Sunday morning new circuit. When January 20th rolls around, Paulson will have earned his retirement.

_______________________________________________________________

C+
Jeffrey Immelt, CEO General Electric
MBA- Harvard Business School

Image: AP

Under Immelt's leadership, GE has increasingly turned to its GE Capital unit to fund the company's growth. A reliance on wholesale funding subject to consumer confidence has put GE at risk; rumblings are already being heard of a potential downgrade of GE's coveted AAA-credit rating.

______________________________________________________________

C-
Neel Kashkari, Office of Financial Stability

MBA- Wharton
Image: Ghetty

Despite his important role as manager of the largest bailout effort in American History (the $700B Troubled Assets Relief Program, or TARP), Kashkari has been virtually invisible to the public. Under his leadership the program has come under constant criticism for its lack of oversight and transparency. His office still refuses to release the names of financial services firms who have received funds from TARP. Public mistrust of how the program is being managed has poisoned the waters for the ongoing auto bailout effort.

______________________________________________________________
C-

George W. Bush, President
MBA- Harvard Business School

Image: ABC News

Presidential legacies are often defined by the economic conditions of their tenure, and MBA-in-chief George W. Bush will probably carry much of the historical blame for this recession. Already a lame duck when this crisis hit, Bush immediately outsourced leadership to Henry Paulson and Ben Bernanke- a wise decision given that his prior exhaustion of the public's trust rendered him unable to personally lead the effort. Bush's inability to lead now should not completely overshadow the efforts his administration took to prevent this crisis. In 2003 he proposed comprehensive regulations for Fannie Mae and Freddie Mac, only to see them shot down by members of Congress.

______________________________________________________________

D+
Rick Wagoner, CEO General Motors

MBA- Harvard Business School
Image: ABC News

Rick Wagoner will forever be remembered for his decision to fly to Washington D.C. in a private jet in order to ask for taxpayer bailout funds. Under his leadership, GM missed numerous opportunities to avoid its current fate, clinging to white elephants like SUV's and fuel-cell cars while the Japanese grabbed market share with desirable, fuel-efficient cars. Congress is unlikely to care that during his tenure, Wagoner implemented major changes at GM, without which the company would likely have gone bankrupt several years ago. As it stands today, any bailout package is sure to include a required exit for Mr. Wagoner.

______________________________________________________________
D+

James Lockhart, Director Federal Finance Housing Agency

MBA- Harvard Business School

Image: Getty

As head of the organization that assumed conservatorship of Fannie Mae and Freddy Mac earlier this year, Lockhart has acted decisively, offering innovative solutions like protecting tenants living in foreclosed properties. But where was that leadership over the last six years? As head of the now-defunct Office of Federal Housing Enterprise Oversight (OFHEO), Lockhart should have been sounding the alarm about the coming crisis. While special interests in Congress carry some of the blame for holding Fannie and Freddie hostage, it is the job of a regulator to call attention to abuse, and if ignored, publicly resign to bring attention to the issue.

______________________________________________________________

D-
Stan O'Neal, former CEO Merril Lynch
MBA- Harvard Business School
Image: Merril Lynch

After leading Merril Lynch into $2.24B in subprime-related losses, Stan O'Neal secured his own ouster by approaching Wachovia for a deal...without the board's approval. He walked away from the "thundering herd" with a $161M severance package. Merril Lynch proceeded to write down an additional $16.7B of subprime assets in Q4 2008. Quite a bargain, indeed.

______________________________________________________________
D-

Chris Cox, SEC Chairman

MBA- Harvard Business School

Image: The New York Times

Chairman Cox and his predecessor, fellow HBS alum William Donaldson, have done an effective job of demonstrating the complete ineffectiveness of the SEC as a regulatory agency. His belated ban on naked shortselling did not come until mid-September- the same month that he suspended the "voluntary regulation" that had clearly worked so well for the investment banks. In the last few days it has come to light that the SEC could have shut down the Bernard Madoff scheme years ago, but somehow managed to drop the ball....
______________________________________________________________
F

Kerry Killinger, former CEO Washington Mutual
MBA- University of Iowa

Image: Flickr

Few companies made bigger bets on the sub-prime mortgage market than Washington Mutual, and few leaders have failed so spectacularly as Kerry Killinger. Under his leadership, WAMU built up $16B in subprime loans on its way to becoming the 6th-largest bank in the country. A bank run in September forced the company into receivership, the largest to ever occur in the FDIC's history. JP Morgan acquired the holding company in a transaction that completely wiped out WAMU's equity holders.

______________________________________________________________
F-

Richard Fuld, former CEO of Lehman Brothers
MBA- NYU Stern
Image: Reuters

The former CEO of failed investment bank Lehman Brothers rounds out the bottom of our MBA grading chart. His utter mismanagement of one of the nation's historic firms led to a bankruptcy that could have easily been avoided. It proved to be the spark that set off the fire that soon engulfed the entire financial sector. While other bank CEOs also made bad bets in subprime, their leaders had the good sense to either sell the company, ask the government for help or that failing, get out of the way and let somebone else try. Fuld stubbornly refused to accept the reality that his firm was sinking, eventually going down with the ship and taking thousands of employees with him.

Obama’s Health Plan & the Physician Shortage

Healthcare costs continue to skyrocket and 47 million Americans are without health insurance. President-elect Barack Obama’s health care plan is “to provide affordable, accessible health care to all.” Obama recently named Tom Daschle secretary of health and human services. The posting Review of the CBO’s Annual Report to Congress highlighted raising health care costs as one of the primary drivers of the US Government’s budget deficit in the coming decade. Much of Obama’s plan is focused on the affordability aspects of healthcare, with limited emphasis on the accessibility of health care. A universal health care system may provide insurance to the millions of uninsured, but it will not provide doctors for the uninsured. Massachusetts health care reform has provided insurance to many previously uninsured, but the plan has not provided physicians to the newly insured.

The aging US population is driving a need for an increase in primary care professionals; unfortunately, the number primary care professionals has been declining at dramatic rates over the past decade. The American Medical Association (AMA) predicted a shortage of 35,000 to 40,000 primary care physicians at its 2008 annual meeting. The AMA has three primary tools to mitigate the physician shortage, (1) debt forgiveness, (2) recruitment and training, and (3) increased insurance reimbursement rates. Increased pay via debt forgiveness and reimbursement would certainly help bridge the gap in salaries between primary care and specialists, but a recent CNN article Half of primary-care doctors in survey would leave medicine reports that red tape with insurance companies and government agencies as well as malpractice insurance are the reasons physicians are considering leaving the industry. Additionally, physicians are closing their practices to Medicare and Medicaid patients, one-third and 12% of physicians respectively – highlighting the lack of available health care for Americans.

Obama’s plan is focused on reducing the cost side of health care, primarily through improved information technology infrastructure and increased competition among insurers, theoretically reducing premiums. The plan does touch on the health care workforce as an important component of the plan. His vague solutions include loan repayment, adequate reimbursement, training, and infrastructure support. The IT infrastructure should be a positive step to reducing the ‘red tape’ associated with reimbursements and anti-competitive measures in malpractice should help reduce the costs for primary care physicians. Daschle would like to create the Federal Health Board to set guidelines for cost-effective treatments.

Suggested Policy Reform
Malpractice – The best way to reduce the cost of malpractice insurance is to reduce the outflows for insurance companies. Reduce malpractices instances – increased professionals and appropriate reimbursement rates should reduce the workload for physicians, increasing the time with patients there by reducing the number errors. Malpractice insurance has roughly kept pace with overall health care costs and a Dartmouth study found that lack of financial returns has strained insurers, not huge settlements.

Loan Forgiveness – The US government should provide tax credits to hospitals and clinics that provide loan forgiveness to primary care professionals. Professionals should earn their loan forgiveness through years of service with the organization.

Reimbursement Rates – Insurance and government reimbursement rates should be with respect to cost of care, including time spent with the patient, not based on delivery of specific treatments. More equitable reimbursement rates should help with physician compensation and hopefully the number of medical students choosing primary care.

Carried Interest – Long-term Capital Gains or Ordinary Income

The carried interest debate has taken a back seat given the current turmoil on Wall Street. The carried interest question was lead by Senator Chuck Grassley (R-IA), ranking member on the Committee on Finance. During private equity’s heyday and subsequent Blackstone IPO, politicians began to examine the method of taxation on a piece of PE professional’s compensation – carried interest. Carried interest is designed to align the interests of the general partner and the limited partners in the fund. A private equity fund (LBO or venture) typically has a “2 & 20” structure, 2% annual management fee on committed capital and a 20% incentive fee where after the return of initial capital the general partners and limited partners split every dollar of profit 80 / 20. With Harvard Management rumored to be selling $1.5B in private equity investments at 50¢ on the dollar, it’s unlikely for the carried interest debate to gain much momentum. That said, Barack Obama is in favor of changing the taxation of carried interest, which could be lumped into a broader change in US tax policy.

Capital Gains Supports
Supporters of LTCG treatment stand behind the original intent of LTCG treatment of partnership interest – promoting investment and growth in American business. Eric Solomon’s testimony to Senator Grassley provided support of taxing carry as capital gains. Two reasons are highlighted in defense of the status quo, (i) venture capital and growth private equity promote small business and (ii) changing to OI would make US private equity less competitive in World markets. There is fairly sound logic behind the first argument; treating carried interest as capital gains promotes entrepreneurship through the pooling capital, skills, and ideas as well as risk taking. Gordon Gecko promoted the negative stereotype of private equity investors as corporate raiders, but many private equity firms partner with management to grow business creating and maintain jobs in America.

It is difficult to argue with a venture capital investor that venture and angel investments are providing necessary capital for smart growth. The VC industry was at the heights of its popularity during the tech boom of the late 1990s. The asset bubble the burst in 2002 and subsequent recession provided substantially more good than bad for American business. While many dot coms measured operating results in cash burn, the dot coms created a new industry where the US remains globally competitive and created new technologies that make other industries more competitive. Furthermore, venture investing provides necessary capital for growth in biotech and medtech firms that substantially improve US healthcare; a more recent phenomenon, clean-tech, may help reduce US
dependence on foreign oil.

LBO firms create returns for their LPs, commonly terms are internal rate of return (“IRR”) and cash-on-cash return, using three mechanisms, (i) financial engineering or leverage (a debt-to-equity mix consistent with a home mortgage 10-20% down), (ii) multiple arbitrage or expansion (buying a business at a purchase price multiple of 5x earnings and selling it for 10x earnings) and (iii) earnings growth by way of either revenue growth or operational improvement of the business. A recent BCG study of the viability of the private equity industry highlighted decade long eras in the industry; the 1980s were the leverage era, the 1990s were the multiple expansion era, the 2000s were the earnings growth era, and the 2010s will be the operational improvement era. Through operational improvements, LBO funds may improve the job security of many US workers as well as drive new operational expertise that will transfer to many other firms and industries.

The structural argument for carried interest to be taxed as capital gains surrounds partnerships accounting. The partnership or sole proprietor model was established to avoid double taxation. If the carried interest were taxed at the time of receipt as a profits interest, the partner would be taxed as ordinary income on the present value of the income stream and would again be taxed when the income is recognized by the partnership in the future. Additionally, the carried interest is analogous to an entrepreneur that puts “sweat equity” into a business; with a little seed capital, good ideas, and hard work, entrepreneur’s increase in equity value is taxed at the capital gains rate. It has been further highlighted that lawyers and artist sell skill (ordinary income) while private equity professionals are selling sweat equity in a firm, similar to an entrepreneur. Carried interest differs from options in that options do not have an economic right, cannot vote, and do not have a right to dividends, where as with carried interest, individuals are immediate owners, are taxed on their share of income, and are treated similar to owners.

Ordinary Income
The primary argument to tax carried interest as ordinary income is that carried interest in effectively performance-based compensation. With the huge sums of capital raised in the past decade or so, private equity no longer is flying under the radar; many believe the financial services industry is too highly paid, fleecing public pensions, endowments, and charities. The ordinary income crowd was lead by Peter Orszag, former director of the CBO and Obama’s Office of Management and Budget Director, and his presentation to the Senate Committee on Finance. The carried interest is compensation for services provided by the general partners and not a return on invested capital. At grant, general partners are only required to invest a nominal amount of capital to achieve capital gains taxation. The fund’s limited partners provide all of the capital and bear all of the risk on the downside for the fund. The general partners simply provide sweat equity, thus the limited partners have a right to capital gains and general partners are receiving a performance-based compensation. The main focus of the argument is on the lack of capital at risk.

Alternative Taxation Methods
There are three basic suggested alternative taxation methods for carried interest. The first method would be to tax the carried interest at grant, similar to a non-restricted stock option. The carried interest would be valued similar to an option using an option pricing model (Black-Scholes); the general partner would pay ordinary income tax on the value of the carried interest at grant and the limited partners could take a deduction for the amount. The taxation would accelerate tax receipts for the US government and general partners would pay net capital gains or losses upon revaluation. The method would be slightly cumbersome to value the carried interest, potentially costly to have a third party value, and would leave room for general partners to favorably set assumptions to lower the value. US tax code abides by the notion of convenience, without a corresponding income stream, it may prove difficult for some private equity professionals to pay the tax bill.

A second proposed system would be to pay taxes at distribution as ordinary income – carried interest is entirely performance-based compensation. The carried interest would be treated similar to a nonqualified corporate stock option. The tax deferral would continue as with the current system. Many economists feel carried interest is a mix between incentive compensation and capital gains, full taxation as ordinary income is likely imposes too stringent of a tax.

The third option, which appears to have some merit, is to treat the carried interest as a non-recourse loan from the limited partners to the general partners. In this system, the general partner would pay ordinary income on the implicit interest rate on the loan; the interest would have to be a market rate. In a $100mm fund, the general partner would in effect be receiving a $20mm loan from the limited partners; each year the general partner would have to pay tax on the implicit interest (5% of $20mm = $1mm of interest @ 35% à $350,000 tax bill). This option more closely reflects that a portion of the carried interest is performance compensation and a portion is capital appreciation. Opponents of this option would again point to the convenience factor; it may prove difficult to pay the $350,000 tax bill without an income stream. Limited partners receive a distribution from the fund each year to pay their portion of the annual tax bill to mitigate the convenience issue.

With the US staring down a long recessionary road, incenting providers of capital to continue to prudently deploy the capital for growth is necessary. While it may be difficult to explain to your grandmother why carried interest is not performance-based compensation, it may be best for the US economy to delay an action on carried interest. With all likelihood, policy makers will take action to shift a portion of carried interest to ordinary income. Given a change, the non-recourse loan appears to be the best option. To mitigate the convenience issues, the implicit interest taxation should continue to be delayed until realization. Keep the US entrepreneurial spirit alive.

It doesn't get any easier than this

If politicians are looking to make sure that the economy is stimulated through infrastructure spending, the first stop should be injecting funds to the Highway Trust Fund. The Trust is funded by gasoline taxes, and since Americans are driving less and less, the Trust is running low on funds. The infrastructure projects funded by the Trust are not only vital to maintaining the nation's competitiveness in infrastructure, but also provide jobs to those construction workers.

While Congress passed a temporary patch earlier this year, the drop in gasoline consumption paired with a need for economic stimulus provides a perfect opportunity for the incoming administration to massively invest in infrastructure. Since the Trust is a well-known entity that already exists, the existing mechanisms will allow dollars to flow to projects more quickly than if stimulus is routed through new organizations.

Just as promised

The UAW and Senate Republicans are having a hard time agreeing on what "reasonable" sacrifices must be made by labor to make bailing out the automakers acceptable. Not too surprisingly, the process is becoming highly politicized. Now, imagine repeating this process with bondholders, management, shareholders, suppliers, dealers, etc., with each party peddling influence, votes, campaign contributions, and threats to try to obtain the biggest slice of the pie for themselves.

When decisions normally made by market mechanisms are instead made by politicians, this is an inevitable result. The market mechanisms available in a Chapter 11 restructuring process would be better suited to making these decisions than the political lobbying mess currently being used. This space earlier called for a modified Chapter 11 bankruptcy, and that solution still appears to be best.

The government should provide debtor-in-possession financing and warranty guarantees to the automakers, appoint a systematic risk regulator to ensure the court does not inadvertently endanger the broader economy, and then let the bankruptcy process work. Hopefully Congress has this solution - which, considering its more stringent impact on all players, should be able to pass both houses - in the works already, as it may need to be passed in a hurry if the Unions' and Senate Republicans' game of chicken lasts so long the companies run out of cash.

SEC Drops the Ball – Madoff Investment Securities and Consolidated Supervised Entities

On December 11, 2008 former NASDAQ Chairman, Bernard L. Madoff, was arrested for securities fraud relating to his firm Bernard L. Madoff Investment Securities LLC. Madoff admitted to his senior employees that he was effectively running a giant ponzi scheme and the fraudulent losses may total $50 billion. Madoff’s business included investment advisory ($17.1B AUM), a NASDAQ market maker ($700mm in capital), and a broker dealer.

As a broker dealer and market maker where was the SEC? Perhaps the SEC was turning a blind eye, or simply trusting their own. Bernie Madoff has been in the securities business since the 1960’s and was the former Chairman of the NASDAQ. The SEC’s basic mission is to protect investors:

“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”

“The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds.”

Madoff’s firm was not taking capital from naive retail investors; Madoff’s investors included the $7.3B Fairfield Sentry Ltd and the $2.8B Kingate Global Fund Ltd. These sophisticated, qualified investors likely did not complete all of the necessary diligence on the firm. Madoff utilized a split strike conversion strategy which is an option arbitrage strategy trading equity and at-the-money puts verse out-of-the-money calls. Despite this complicated, volatile, esoteric strategy, Madoff generated consistent high single-digit returns with limited volatility. Furthermore, CNBC reports the hedge fund due diligence firm Aksia found a 2005 letter to the SEC stating that Madoff was running a “ponzi scheme”.

The Madoff disaster highlights the continued lack of oversight from the SEC. The SEC allowed investment banks to have voluntary supervision which has no doubt fueled the problems facing Wall Street today. In August 2004, the SEC past Consolidated Supervision of Broker-Dealer Holding Companies, allowing large investment banks, labeled consolidated supervised entities (CSE) to be regulated at the holding company level as opposed to regulating the banks individual business lines. The goal was to reduce the amount of duplicate oversight from the regulatory body. The SEC required Require that CSE holding companies maintain regulatory capital commensurate with the risk of their activities. The SEC state “the amendments should help the Commission to protect investors and maintain the integrity of the securities markets by improving oversight of broker-dealers and providing an incentive for broker-dealers to implement strong risk management practices.” The Basel Standards established three Basel “Pillars” to assess the CSEs, minimum regulatory capital, supervisory review, and disclosure of the capital, risk exposures, and risk assessment processes of the institution.

While the SEC may be stretched too thin, the self-governing system was not adequate to regulate the banks. The banks appeared not to have understood the amount of risk exposure in the credit markets or the potential counter party risk of the credit default swap market. Only a few institutions saw the credit crisis coming, but perhaps with greater oversight of the broker dealers, alternative asset management firms, and market markers, the SEC could have pooled this knowledge to require larger capital requirements for the CSEs. On the heals (hopefully no the toes) of this financial crisis, the US Government should reassess the role of the SEC and potentially even increase the resources available to the regulatory body.

The lesser of two evils

Lawmakers this evening gave up on talks for an auto bailout, with union concessions (or lack thereof) being the major disagreement. There are numerous problems in the original House bill. By subordinating other creditors to the government's claim, the government has a Constitutional issue with the takings clause. The car czar will be subjected to more political pressure than the governor of Illinois. And it is unreasonable that current equity holders won't be totally wiped out - with 20% warrants, existing equity holders will retain more than half of the equity.

For all of its faults, the bill would ensure that the automakers avoid a Chapter 7 liquidation, a disaster scenario that would wreck havoc on the American economy. Senate Republicans have sensible objections that should be resolved. But that is not an excuse for doing nothing. Both sides need to swallow their objections and find a compromise bill that can pass both chambers. Passing a flawed bill is better than passing no bill at all.

Wall Street isn't the only place that misunderstands incentives...

Amidst the flood of bailout programs, the FDIC's program to expand insurance to unsecured bank debt has received relatively little attention. The FDIC program - the Temporary Liquidity Guarantee Program (TLG)- essentially extends FDIC's Deposit Insurance Program to banks' bonds. Without this insurance, banks could experience "bank runs" caused by bondholders' unwillingness to refinance bonds as they come due. Of the virtues one would want in a government intervention, this program has many. It is highly effective in its objective, it keeps government separated from management decisions, and it minimizes cost to taxpayers. However, the FDIC plan is rife with moral hazard issues that could be minimized using existing FDIC mechanisms.

This program turns FDIC into an AIG-like bond insurer: participating banks pay an insurance premium to have their debt insured against losses. AIG insured $500B in bonds, and required several hundred billion dollars of capital injection. The FDIC plan insures over $1.4 trillion in debt, with no initial capital other than fees collected through the program. These fees are based solely on the how long the debt will be guaranteed for, at a maximum of 1% of insured capital. This implies less than 1% of losses. Losses in excess of that would be funded by special assessments on existing banks (although backed by the full faith and credit of the government).

This mechanism, while eliminating direct costs to taxpayers, is one of two moral hazard problems in the TLG. The first is the special assessment: a responsible bank would now be on the hook for the mistakes of the less prudent banks. If a bank has to pay for the downside of bad loans whether they make them or not, shouldn't they make bad loans so they can at least participate in the upside? Massive TLG assessments on prudent banks incentivize banks to take risky bets so that they can participate in both the upside and downside of bad loans - just the opposite of the behavior the FDIC would like.

Second, the FDIC - for reasons unknown - decided to charge rates on newly secured deposits independent of the riskiness of banks. The normal insurance progam charges different fees based on capital levels and oversight. Banks that take on additional risks to deposits again gain upside without having to pay for it under the current pricing. Instead, fees should increase when banks increase risk, aligning incentives to make good loan decisions.

The FDIC should scale the fees charged by this program using the existing risk-based deposit system, and Congress should alleviate the moral hazard of the TLG by capitalizing the insurance fund directly instead of charging conservative banks for the poor lending of their competitors. While Congress is considering this issue, they can fix the same flat-rate distortion that exists in other government schemes, such as the Pension Benefit Guaranty Corporation.

You know people are thinking about moral hazard when...

Stuff like this starts making the rounds on the Internet (from Vanity Fair):

UPDATE: The future of campaign finance

Last month the Review tackled the issue of America's failed campaign finance laws. In today's Wall Street Journal, Karl Rove has written an op-ed piece confirming many of our assertions. He argues that money is THE most important resource in waging a successful state-by-state electoral victory:

Mr. Obama outspent Mr. McCain by the biggest margin in history, perhaps a quarter of a billion dollars....He buried Mr. McCain on TV.A state-by-state analysis confirms the Obama advantage. Mr. Obama outspent Mr. McCain in Indiana nearly 7 to 1, in Virginia by more than 4 to 1, in Ohio by almost 2 to 1 and in North Carolina by nearly 3 to 2. Mr. Obama carried all four states. Mr. Obama also used his money to outmuscle Mr. McCain on the ground, with more staff, headquarters, mail and a larger get-out-the-vote effort. No presidential candidate will ever take public financing in the general election again and risk being outspent as badly as Mr. McCain was this year. And even liberals, who have long denied that money is political speech that should be protected by First Amendment, may now be forced to admit that their donations to Mr. Obama were a form of political expression.

Love or hate him, Karl Rove has proved himself an extremely astute observer and practitioner of American politics. He steered Bush away from federal funding in both campaigns. David Axelrod took a page from his book and followed suit. Congress should take note.

Kyoto? Kyoto? Anybody seen Kyoto?

As the Obama administration-to-be gets set to unveil its amibitious plan to make the economy more energy efficient, perhaps it is a good time to revisit our old friend, the Kyoto Protocols. For those of you following at home, the Kyoto Protocols were the international framework developed during the early 90s (finally adopted in 1997) designed to set a path forward in limiting the amount of greenhouse gases that were released into the atmosphere.

One of the biggest stumbling blocks for the Kyoto Protocol in the United States is the differential treatment of developed and developing countries. The protocol set mandates for the US and most of the countries in the EU to reduce emissions back to 1990 levels, but did little to curb emissions in China, India, and the rest of the developing world. The best estimates indicate that in 2006, China emitted 6200 megatonnes of greenhouse gases while the United States only emitted 5800 megatonnes. Furthermore, China's emissions are growing at a much faster rate than the US. While obvious math indicates that China's emissions are much lower on a per capita basis, opponents to the Kyoto Protocols latched on to this and other arguments (e.g. competitiveness) in order to prevent ratification of Kyoto in the Senate.

Last week, the Belfer Center released this report detailing a few modifications that could be made to address some of the shortcomings of the Kyoto protocol and move the discussion on greenhouse gas emissions reduction forward.

The shorcomings are as follows:
1. The largest emitters are not constrained by Kyoto (US and China)
2. Small number of countries asked to take action
3. Nature of the Protocol's emissions trading is seen as ineffective and hard to implement
4. Five year time horizon is essentially a very short-term view on a long-term problem
5. Insufficient enforecement / incentive mechanisms exist

There are three features of the paper which bear mentioning:
First, the need to institute an international system of carbon taxes (more to come on these later). Perhaps unsurprisingly, it seems that the quickest way to alter the quantity demanded of products or services that are carbon intensive is to distort the price through a tax. If the collection is done upstream (the coal mine, the oil rig, or the natural gas field) it is incredibly easy to implement. Harmonizing this system across regions is incredibly valuable since it creates relatively few variables to manage while trying to influence consumption.

Also, deforestation policies need to be included in any new international framework. This often doesn't get mentioned in the debates regarding greenhouse gas emissions, but it is incredibly important. Forests tend to consume huge amounts of carbon dioxide and can serve as a relatively low cost way to reduce the amount of carbon dioxide emitted without actually altering quantity demanded.

Finally, an incredibly important area of consideration should be creation of green technologies through private and public methods. This is where climate change can fit part and parcel into an Obama administration stimulus plan. Conventional theory holds that the record government spending deficits created as a result of World War II stimulated the economy by increasing investment and reducing unemployment. If government spending deficits financed a similar reduction in unemployment and investment in green technology, the country could pull itself out of the current recession and invest in infrastructure that will improve long-run efficiencies. While this may not immediately improve or even return standard-of-living to pre-recession levels, it will certainly create a healthy platform for long-term stability and growth (much as winning World War II did).